Insider–Outsider Theory

The core idea

In the classical labor market model, if unemployed workers offer to work for less, wages should fall until unemployment disappears. So why do firms not take up such offers? Assar Lindbeck and Dennis Snower (1986, 1988) focused on labor turnover costs, the costs of replacing incumbent workers with newcomers. These include recruitment and screening, severance pay and legal procedures, training, and even incumbents' refusal to cooperate with or harassment of entrants. Because insiders cannot profitably be replaced unless outsiders undercut them by more than these costs, insiders can capture the resulting rent as higher wages, often through unions. Outsiders who would gladly work for less still cannot get hired, which offers an explanation of involuntary unemployment. Robert Solow (1985) analyzed the role of insiders in wage setting at around the same time.

Hysteresis and European unemployment

Olivier Blanchard and Lawrence Summers (1986) extended the theory to macroeconomics to explain why high European unemployment in the 1980s did not fall when the economy recovered. Workers laid off in a recession become outsiders, and the remaining insiders set wages to protect only their own jobs, so employment does not recover. This tendency for temporary shocks to raise unemployment permanently is called hysteresis, and it challenged the idea that unemployment returns to a unique natural rate. Long-term unemployed workers losing skills and search intensity further weakens outsiders' competitive pressure and reinforces hysteresis. On this view, strong employment protection can make unemployment more persistent; Lindbeck and Snower (2001) summarized how seniority rules and firing costs strengthen insider power.

Comparisons and research on dualization

The theory resembles efficiency wage theory (Shapiro and Stiglitz, 1984) in explaining above-market wages, but locates the cause in insiders' bargaining power rather than firms' productivity motives. It also connects to Doeringer and Piore's (1971) internal labor markets and dual labor market theory. Later work used the framework to analyze the divide between permanent and temporary workers. Blanchard and Landier (2002) argued that France's expansion of fixed-term contracts added outsiders while leaving permanent workers' protection untouched, and Bentolila et al. (2012) treated Spain as a textbook case. In political science, Rueda (2005) and Emmenegger et al. (2012) studied how parties and welfare states represent insiders and outsiders differently, leading the debate on labor market dualization.

FAQ

What is insider–outsider theory in simple terms?

People already employed can earn higher wages because replacing them is costly for firms, so the unemployed struggle to get hired even if they offer to work for less.

What is hysteresis in unemployment?

It is when unemployment that rose because of a temporary shock, such as a recession, stays high instead of returning to its earlier level after the shock fades.

Sources reviewed: 2026-10-26

References

1. Lindbeck, A., & Snower, D. J. (1986). Wage setting, unemployment, and insider-outsider relations. American Economic Review, 76(2), 235–239.
2. Lindbeck, A., & Snower, D. J. (1988). The Insider-Outsider Theory of Employment and Unemployment. Cambridge, MA: MIT Press.
3. Lindbeck, A., & Snower, D. J. (2001). Insiders versus outsiders. Journal of Economic Perspectives, 15(1), 165–188.
4. Blanchard, O. J., & Summers, L. H. (1986). Hysteresis and the European unemployment problem. NBER Macroeconomics Annual, 1, 15–78.
5. Solow, R. M. (1985). Insiders and outsiders in wage determination. Scandinavian Journal of Economics, 87(2), 411–428.
6. Doeringer, P. B., & Piore, M. J. (1971). Internal Labor Markets and Manpower Analysis. Lexington, MA: D.C. Heath.
7. Shapiro, C., & Stiglitz, J. E. (1984). Equilibrium unemployment as a worker discipline device. American Economic Review, 74(3), 433–444.
8. Gregory, R. G. (1986). Wages policy and unemployment in Australia. Economica, 53(210), S53–S74.
9. Saint-Paul, G. (1996). Dual Labor Markets: A Macroeconomic Perspective. Cambridge, MA: MIT Press.
10. Blanchard, O., & Landier, A. (2002). The perverse effects of partial labour market reform: Fixed-term contracts in France. Economic Journal, 112(480), F214–F244.
11. Rueda, D. (2005). Insider–outsider politics in industrialized democracies: The challenge to social democratic parties. American Political Science Review, 99(1), 61–74.
12. Bentolila, S., Dolado, J. J., & Jimeno, J. F. (2012). Reforming an insider-outsider labor market: The Spanish experience. IZA Journal of European Labor Studies, 1, 4.
13. Emmenegger, P., Häusermann, S., Palier, B., & Seeleib-Kaiser, M. (Eds.). (2012). The Age of Dualization. Oxford: Oxford University Press.